SINGAPORE (11 June): With the US Federal Reserve releasing a generally dovish message during its June Federal Open Market Committee (FOMC) meeting, Bank of Singapore (BoS) analysts Eli Lee and Conrad Tan expect no interest rate hikes over the next two years. The US central bank, they argue, wishes to avoid a possible Quantitative Easing (QE) temper tantrum and rate acceleration that could scupper risk asset price recovery.
“We’re not thinking about raising rates. We’re not even thinking about thinking about raising rates,” insisted Fed chairman Jerome Powell in a post-meeting press conference.
The Fed continues to expect a short recession and a long-drawn out recovery (L-shaped). The US economy is likely to contract by 6.5% in 2020 before growing 5% in 2021 and 3.5% in 2022. Unemployment is likely to be 9.3% in 2020 before dropping to 6.5% in 2021 and 5.5% in 2022.
As expected, Fed fund rates remain unchanged at 0%-0.25% with no change in forward guidance, keeping conventional monetary policy broadly expansionary. The Fed has vowed to maintain this range target until the economy is on track to achieve maximum employment and price stability goals. Its dot plot predicts stable policy rates over the next two years, with median expectation of long-term fund rates remaining at 2.5%.
Quantitative Easing (QE) is also likely to be stepped up from the current pace of US$80 billion ($111.1 billion) worth of treasuries and $40 billion worth of agency MBS created each month. The Fed has announced its intention to increase its holdings of Treasuries Securities and agency residential and commercial mortgage-back securities at least at the current pace to keep markets functioning smoothly.
Despite these expansionary measures, inflation will unfortunately fall short of the Fed’s 2% target for 2020-2022, highlighting the strong deflationary pressures brought on by Covid-19. The core personal consumption expenditure (PCE) index -- the Fed’s preferred inflation measure -- is expected to grow only 1% in 2020 and increase to 1.5% and 1.7% respectively in 2021 and 2022. The Fed is therefore unlikely to be in any hurry to conduct a rate hike so long as these pressures continue to keep US inflation below 2%.
“The market did not expect anything less than a resolutely supportive message from the Fed, and the key areas of the June FOMC outcome were broadly in line with expectations, in our view,” say Lee and Tan. Market responses to this macroeconomic report were largely muted or mixed. While equities weakened slightly, the Treasury curve experienced a mild bull steepening, with yields gained 2-4 base points across the curve.
The analysts have hailed the Fed response as a prudent and well-calibrated move that would give the central bank more time to assess the trajectory of recovery and evaluate the evolution of forward guidance over time ahead of the next FOMC meeting in September. They suggest that it may consider adopting yield curve targets going forward, targeting longer term rates and keeping them at a set level as opposed to raising or lowering short-term interest rates as usual.
At the front of the analyst’s minds is the possibility of a “taper tantrum” like in 2013, where investors panicked on hearing that the Fed was cancelling one of its QE programs, resulting in capital flight from the bond market and an exponential rise in bond yields. By taking action to effectively end the taper of its market functioning QE by committing to at least a constant pace of monthly asset purchases, the Fed is looking to avoid the potentially destabilising effects of a taper tantrum in an uncertain period, where markets are anxious about a second wave of Covid019 and the result of the upcoming US Presidential elections.
Lee and Tan therefore have maintained an overweight position on fixed income assets in their recommended asset allocation strategy. The search for yield, they predict, will continue to be a powerful market driver. The Fed’s decision to maintain or further decrease rates, combat deflationary risks and potentially make use of yield caps to provide forward guidance appear to suggest that interest rates are likely to remain lower for a longer period of time going forward.
